Successful contractors combine a keen sense for the costs of doing business with strong management skills to complete the work on time and within budget. Yet even the best of the best can wind up leaving money on the table when their front office estimating and negotiating professionals get out of alignment with their back office accounting staff.
In an ideal world, each contract provides for recovery of all reasonable costs associated with the job. Job costs fall within one of three categories:
- Direct costs that are specific to the job, such as direct labor, materials, equipment rentals, and subcontractor costs
- Indirect costs associated with the job but not exclusive to it, such as estimating, job supervision, non-job chargeable time (e.g., shop labor, vacations, holiday, sick leave, benefits), consultants and third party providers, small tools and supplies, depreciation on shared equipment, and liability insurance
- Overhead expense, such as general office and administrative expense, advertising, travel and entertainment, and professional licenses
Direct costs are the easiest (and largest) expenses to track as they’re identifiable as being directly associated to the job. Yet indirect costs and overhead can represent a significant outlay. They frequently include elements that fail to be covered in bids. If such costs aren’t considered before signing on the dotted line, they can’t be recovered after the fact. For instance, how much are you willing to spend on pre-contract costs without considering how they may be recovered from a prospective client? Should they be considered a sunk cost of overhead (cost of doing business), or could pre-contract costs be included as part of the negotiated contract price?
In addition to direct costs, the company needs to determine the means through which it will allocate your indirect costs and overhead to specific jobs. Common allocation methods include:
- Assigning a fair market hourly, daily, or monthly rate to a cost, or pool of costs, resources (e.g., estimating labor, general liability insurance, etc.) and applying that rate based on a reasonable allocation base, such as labor dollars/hours or machine hours.
- Recapture historical operating and ownership costs of your equipment (depreciation, maintenance, repair, licenses, insurance, etc.) to determine usage rates and applying them to the actual machine hours recorded on the job.
- Distributing actual costs incurred based on the percentage of time the resource was assigned to each project during the period.
- Apportioning costs based on the percentage of revenue or costs attributed to the job relative to the company’s aggregate revenue or costs.
Some contracts dictate how costs are allocated; others simply require that a fair and reasonable method be employed subject to certain limits. Companies generally opt for a straight-forward allocation methodology when the associated line items are relatively small. If the line item expense is significant, it may merit a more sophisticated methodology. For example, some contractors may assign a set fee for use of small tools and supplies because the cost of tracking outweighs any financial gain. A large industrial construction contractor might send a pre-loaded container with tools and supplies to each job site for which the job is charged a monthly fee. When the container is returned at the end of the job, a physical inventory of the remaining assets determines the final adjustment to job costs.
If the job is subject the federal government’s Cost Accounting Standards (CAS), each cost must be reasonable, allowable, and allocable in order to be charged to that job. “Reasonable costs” are defined as expenses deemed necessary for the performance of the contract and incurred using generally sound business practices (e.g., arm’s length bargaining). “Allowable costs” reflect expenses that have been specifically approved according to the terms of the contract. Certain costs are expressly disallowed, such as entertainment. “Allocable costs” are expenses that benefit multiple programs and/or supporting activities (e.g., information technology) and can be reasonably distributed in proportion to the benefits received. All such costs must have appropriate supporting documentation and demonstrate consistent treatment over time.
The accounting department and their expert advisors can be strong allies in creating templates to ensure all reasonable costs are addressed during the bidding process. They can also help ensure contracts provide fair and reasonable mechanism for cost recovery. And, of course, they’ll need advance warning regarding the requisite documentation trail so they’ll be ready to go when the first billing cycle ends.
To the extent possible, the company should leverage standardized policies and procedures for cost allocations that are applied consistently. Standards simplify tracking and reporting for field operatives and lighten the load on back office personnel. It also provides a means of comparing budget-to-actual costs and and the resulting profit margins on completed jobs.
Those tempted to bypass the job costing conversation for “lump sum” contracts do so at their peril. The underlying cost data will become paramount if the need arises to support a change order or initiate a legal claim against the contract. A strong position can be very difficult to support if the company tries to pull the information together after the fact and/or during litigation.
In summary, it pays to establish good working relationships between the front office staff who’ll secure the business and the back office staff who’ll be charged with tracking expenses and collecting payment. Each has valuable expertise that can help the company prosper financially while protecting its vital interests.
Meet the Author
Gary Alongi, CPA, CCIFP®
Aldrich CPAs + Advisors
Gary brings over two decades of experience helping his clients reach their highest level of success. His extensive knowledge of the construction industry allows him to provide value-added services that save clients money, helps them comply with regulations and requirements, and take advantage of opportunities helping them grow their business. American Institute of Certified Public…
- Audit and assurance services
- Certified Public Accountant
- Overhead rate (FAR 31) audits and compliance
- Certified Construction Industry Financial Professional (CCIFP®)